A Project Report on Managerial economics

Topic:
What do u understand by Celling Price and Floor Price?
Explain its consequences?

Submitted By

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(First Semester, MMS, Division B)

Under the guidance of Dr. Hema Jaganathan

GOVERNMENT INTERVENTION IN MARKET PRICES

In some markets, governments intervene to keep prices of certain

items higher or lower than what would result from the market finding
its own price.

We also see this in the form of price celling, where the government
will not allow a price to rise to its market level because of a belief or
political pressure that the market determined price is too high (rent
control).

We see this in the form of price floor, where the government will
not allow a price to fall its market level because of a belief or political
pressure that the market determined price is too low (minimum wages
laws, agricultural price supports).

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 PRICE CEILINGS
A price ceiling occurs when the government puts a legal limit on how high the
price of a product can be. In order for a price ceiling to be effective, it must be
set below the natural market equilibrium.
It is also known as maximum price.

When a price ceiling is set, a shortage occurs. For the price that the ceiling is set
at, there is more demand than there is at the equilibrium price. There is also less
supply than there is at the equilibrium price, thus there is more quantity demanded
than quantity supplied. An inefficiency occurs since at the price ceiling quantity
supplied the marginal benefit exceeds the marginal cost. This inefficiency is equal
to the deadweight welfare loss.

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This graph shows a price ceiling. P* shows the legal price the government has
set, but MB shows the price the marginal consumer is willing to pay at Q*, which
is the quantity that the industry is willing to supply. Since MB > P* (MC), a
deadweight welfare loss results. P' and Q' show the equilibrium price. At P* the
quantity demanded is greater than the quantity supplied. This is what causes the
shortage.

Recent increases in the price of gas have left many individuals asking for a price
ceiling on gas. You now see why this is a bad idea. If the government sets a price
ceiling on gas, there will be a shortage. Remember the long gas lines in the
1970's? This is exactly what happened.

If a price ceiling is set, then there must be a way to assign who gets the low supply
of the product. Of course, since there is a legal limit on the price, the price can't
simply be raised. There are several ways this is done without raising the price:

Lottery: One way to distribute a product for which there is a shortage is

to draw names out of a hat. In some states there is a high demand to be
able to hunt for moose, but the government has a limit on the amount of
permits it gives out. Often these states have a lottery and if you are lucky
enough to get drawn, you can try your luck at finding and shooting a
moose during the season.

Black Market: For those lucky enough to get some of the short supply,
they are often better off selling what they have obtained to the
demanders that will get more benefit out of it. In some cities there have
been ceilings put on the apartment rent. While the demand for
apartments increases, the rent remains the same. When some renters are
ready to move, they sublease their apartment instead of ending their
contract. If they were renting for $500, but someone is willing to pay
$1000, then the sublease can continue paying $500 and pocket the extra
$500 he gets from the sublease.

Queue/First Come First Serve: Had they raised the price of tickets to
$100 the opening night of Star Wars: Episode I, I wouldn't have been

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 willing to camp out two nights to get a ticket. Since they didn't let the
market determine the price, however, there was a huge line and those
that were there first got to buy tickets. Of course, in this case they may
have wanted the "buzz" that would come from having people camp out
a week early just to get tickets, but there are other cases where a buzz
isn't useful.

Historical Use: Sometimes the government will allow the consumers

that were already consuming to continue consuming. This would be
hard to do since after the price ceiling there will be many more people
claiming they have consumed in the past. Also, the quantity supplied is
decreased which will even leave some of the historical consumers
wanting.

Inefficiency: Inefficiency occurs since at the price ceiling quantity

supplied the marginal benefit exceeds the marginal cost. This
inefficiency is equal to the deadweight welfare loss.

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Price Floor
A minimum allowable price set above the equilibrium price is a price floor.
With a price floor, the government forbids a price below the minimum Price
Floors are minimum prices set by the government for certain commodities and
services that it believes are being sold in an unfair market with too low of a price
and thus their producers deserve some assistance.

A price floor is the lowest legal price a commodity can be sold at. Price floors are
used by the government to prevent prices from being too low. The most common
price floor is the minimum wage--the minimum price that can be payed for labor.
Price floors are also used often in agriculture to try to protect farmers.

Government might set Minimum prices

To raise incomes for producers such a farmers and protect them from frequent
fluctuations in the commodity market.
To protect workers and ensure that they get a enough wages to sustain a
reasonable standard of living.
For a price floor to be effective, it must be set above the equilibrium
price. If it's not above equilibrium, then the market won't sell below equilibrium
And the price floor will be irrelevant.

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 Drawing a price floor is simple. Simply draw a straight, horizontal line at
the price floor level. This graph shows a price floor at $3.00. You'll notice that
the price floor is above the equilibrium price, which is $2.00 in this example.

A few crazy things start to happen when a price floor is set. First of all, the price
floor has raised the price above what it was at equilibrium, so the demanders
(consumers) aren't willing to buy as much quantity. The demanders will purchase
the quantity where the quantity demanded is equal to the price floor, or where the
demand curve intersects the price floor line. On the other hand, since the price is
higher than what it would be at equilibrium, the suppliers (producers) are willing
to supply more than the equilibrium quantity. They will supply where
their marginal cost is equal to the price floor, or where the supply curve intersects
the price floor line.

As you might have guessed, this creates a problem. There is less quantity
demanded (consumed) than quantity supplied (produced). This is called a surplus.
If the surplus is allowed to be in the market then the price would actually drop
below the equilibrium. In order to prevent this the government must step in. The
government has a few options:

1. They can buy up all the surplus. For a while the US government bought
grain surpluses in the US and then gave all the grain to Africa. This might
have been nice for African consumers, but it destroyed African farmers.

2. They can strictly enforce the price floor and let the surplus go to waste. This
means that the suppliers that are able to sell their goods are better off while
those who can't sell theirs (because of lack of demand) will be worse off.
Minimum wage laws, for example, mean that some workers who are willing
to work at a lower wage don't get to work at all. Such workers make up a
portion of the unemployed (this is called "structural unemployment").

3. The government can control how much is produced. To prevent too many
suppliers from producing, the government can give out production rights or
pay people not to produce. Giving out production rights will lead to lobbying
for the lucrative rights or even bribery. If the government pays people not to
produce, then suddenly more producers will show up and ask to be payed.

4. They can also subsidize consumption. To get demanders to purchase more

of the surplus, the government can pay part of the costs. This would obviously
get expensive really fast.

Although some of those ideas may sound stupid, the US government has done
them. In the end, a price floor hurts society more than it helps. It may help farmers

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or the few workers that get to work for minimum wage, but it only helps those
people by hurting everyone else. Price floors cause a deadweight welfare loss.

A deadweight welfare loss occurs whenever there is a difference between

the price the marginal demander is willing to pay and the equilibrium price. The
deadweight welfare loss is the loss of consumer and producer surplus. In other
words, any time a regulation is put into place that moves the market away from
equilibrium, beneficial transactions that would have occured can no longer take
place. In the case of a price floor, the deadweight welfare loss is shown by a
triangle on the left side of the equilibrium point, like in the graph. The area of the
triangle is the amount of money that society loses.

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Effects of Price Ceiling

A binding price ceiling has numerous effects. At this point, suppliers can
no longer keep charging what they used to for products at the equilibrium price.
This can force some suppliers leave the market and, in turn, reduces the quantity
supplied in the market. At the same time, those demanding the product can
purchase it at a lower price. This results in an increase in market demand increases
because new buyers will take advantage of the lower market price while those
who already purchase the good will buy even more of it.

The intent of price ceilings is to protect consumers from conditions that would
make certain necessities unattainable. However, serious problems can arise if
they are put into place for an extended period of time and nothing is done to
control rationing. If there is a price ceiling on a medical procedure such as
liposuction, more people would be able to purchase it even though they could not
have purchased it before. While this is a positive situation for them, the market
demand for liposuction will increase, but the supply of doctors able to perform
the surgery will decrease. This will cause a shortage of doctors and prevent those
people that actually need the surgery from getting it.

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Consequences of a price floor
As seen from the diagram. The equilibrium price for a particular good is
Pe and the Quantity demanded is Qe.

The government thinks that it is too low for that good thus they set up a
minimum price for a good P min.
This will lead to a fall in demand to Q1 and increase in supply to Q2, thus creating
excess supply or surplus.
Government can eliminate the surplus by buying the excess supply at the
minimum price. This will result in the shifting of demand curve to the right, thus
creating a new equilibrium at P min.
The Government may store it or sell it abroad. However, both these options have
consequences. Buying the surplus and storing it will cost an opportunity cost for
the government as they have to divert funds from other important areas and
exporting it other countries may be considered as dumping.